Problem 12-23 Calculating the Cost of Equity [LO 1] Laverne Industries stock has
ID: 2725545 • Letter: P
Question
Problem 12-23 Calculating the Cost of Equity [LO 1] Laverne Industries stock has a beta of 1.35. The company just paid a dividend of $.85, and the dividends are expected to grow at 5 percent. The expected return of the market is 11.5 percent, and Treasury bills are yielding 5 percent. The most recent stock price is $83.50. Required: (a) Calculate the cost of equity using the dividend growth model method. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Cost of equity % (b) Calculate the cost of equity using the SML method. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Cost of equity %
Explanation / Answer
(a) As per Dividend Growth Model P0 = D1 / (k-g)
P0 = Current Stock Price = $83.50
D1 = Dividend at Year 1 = D0(1+g) = .85 (1.05) = .8925
k = cost of equity
g = grwoth rate = 5%
83.50 = .8925 / (k - .05)
k - .05 = .010689
k = 6.07%
(b) As per SML Method ,
Where: rf = the risk-free rate
Bs = the beta of the investment
Emkg = the expected return of the market
Es = the expected return of the investment
Es = 5% + 1.35 (11.50% - 5%)
Es = 13.775% or 13.78%
Es = rf + Bs(Emkt - rf)